Covered Bonds: An Investing Stalwart Through the Centuries

By , Money Morning • September 15, 2010

So-called "covered bonds" are debt securities that are backed by the cash flows from public-sector loans or from real-estate mortgages. Covered bonds resemble other asset-backed securities (ABS) created through the process known as "securitization." But there's one big difference: Covered-bond assets must remain on the issuer's consolidated balance sheet.

Created in Prussia in 1769 by Frederick the Great, covered bonds have a long history and through the centuries have become a very popular investment instrument in Europe. There, known as Pfandbriefs, these mostly AAA-rated debentures make up the third-largest segment of the German bond market (behind public-sector bonds and unsecured bank debt).

"In the past few years, covered bonds have enjoyed a resurgence as investors search for high quality investments with attractive yields and as European banks look to finance the growth in mortgage lending," fixed-income heavyweight PIMCO wrote in a 2006 research note to investors.

That "resurgence" has continued. Throughout Europe, total volume outstanding in Pfandbrief bondsreached $1.05 trillion (806 billion euros) as of the end of 2008, the most recent figures available.

Here are some other key covered-bond considerations:

• On July 28, 2008, then-U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. said that the government - with the help of four big U.S. banks - would try to jump-start the market for these securities in the United States.
• U.S. Treasury Department guidelines specifically address covered bonds backed by pools of eligible mortgages.
• The U.S. Federal Reserve also announced that it would potentially consider highly rated covered bonds as acceptable collateral for emergency fund requests.
• Because the U.S. market has already demonstrated its appetite for securitized debt instruments, regulators have been pushing the covered-bond-market strategy.
• The bottom-line objective for covered bonds is to provide an alternative form of mortgage-backed securities. The guidelines issued specifically address covered bonds backed by pools of eligible mortgages.
• For the investor, a key advantage is that the debt and underlying asset pool used to create the covered bond remain on the bond issuer's financial statement. That forces issuers to ensure that the pool backs the covered bond.
• If there is a default, the investor has a recourse - to both the issuer and the pool.
• Interest is paid from an identifiable source of projected cash flow, and not from other financing operations - which is another advantage to investors.

[Editor's Note: Money Morning columnist R. Shah Gilani, a retired hedge-fund manager who is a noted expert on the global credit crisis, says that "covered bonds" may be a solution to the economic malaise currently gripping the country. To understand his financial blueprint for the U.S. economy, please click here to check out his latest column which appears elsewhere in today's issue of Money Morning.]

News and Related Story Links:

• Wikipedia:
  Covered Bonds
• Hyperhistory.com:
  Frederick the Great
• PIMCO:
  Covered-Bond Basics